Sunday, September 11, 2005

(P.S: Sorry for any disturbances the advertisements above may have caused you)

Main issues

1.Extremely high gearing of ~2X

2.Positioning at low-to-mid end of property and hotel segment may not reap it the best benefits of sector-wide reflation

It is rare that I would advise against buying a stock that has been regularly purchased by insiders, but this is one of them. Despite the CEO/chairman Koh Wee Meng regularly making open market purchases since the IPO, I think the share price has now reached a stage where the risk outweighs the opportunity cost (of not buying).

We all know what has provided the impetus for the stock to surge from 30 cents to 60 cents these couple of months. The spotlight on property stocks was first triggered by the rise of REITs, then the purchase of Raffles Group's hotels, then finally the relaxation of regulations governing property purchases by the government. This sudden rise of optimism has benefited the share prices of boutique developers like Ho Bee and Fragrance the most, sending them up 70-100% within two months.

Whether the rise is justified depends on one's view of the property market. To me, the improvement in this sector is real, but only certain segments are likely to benefit strongly because consumer sentiment is still weak after the collapse in prices since 1996. In the residential segment, luxury apartments in prime districts (eg. 9 and 10) and future hotspots are the ones to look out for. That is why I think Ho Bee's rise is more justified, given its excellent positioning in Sentosa projects where optimism will be underpinned by the coming IRs in 2008-9. Fragrance's property development portfolio seems to be in budget areas like Hougang, Serangoon and Balestier. Given the current oversupply of HDB flats and their recently announced plans to introduce design-build-sell apartments built by private developers, the consumer liquidity available for low-range (ie. affordable) condominium units is going to be limited. There is a reason why the big developers choose to develop properties in expensive downtown areas.

Fragrance's other segment is the budget hotel division, which although contributing only 25% of revenue accounts for about half the net profit. Of course, the location of their hotels suggests a certain kind of clientele (guess?), which while generating steady income may not be palatable to general tourists. Not even those travelling by budget airlines, in my view. I have had friends coming to Singpore who actively protested against staying in Geylang/Balestier hotels despite their affordability; they would rather spend more and stay near the city, in mid-range hotels. That's why there was a report recently about a shortage of three-star hotel rooms --- not the lower-end, nor the higher-end.

But to me, the greatest problem with Fragrance lies with its balance sheet and its method of financing. Gearing is extremely high; its long-term bank loans weigh in at >S$100M while shareholder equity is only less than S$50M. Besides having to pay increasing amounts for debt servicing as interest rates increase, it also runs the risk of financial problems should take-up rate of its property developments turn out to be substantially poorer than planned. One only has to look back towards the 1997 financial crisis to see the effects of a collapse in consumer demand for property: the more conservative developers survived, while the heavily leveraged ran into insolvency and were bankrupted. Fragrance has no intention of mitigating this risk as shown in its latest HY05 statement: it paid back S$18M but borrowed another S$34M. Some of this borrowings would be used to pay a 2-cent interim dividend amounting to S$3.4M, in a half where operating cashflow was negative. Clearly Fragrance's management are counting on a better second half (as reflected in the management outlook) and collection of receivables (which had about doubled from S$13M to S$25M). It probably would be, but I would look at other better-financed property stocks with more reasonable valuations (some with P/NTA<1) rather than Fragrance (P/NTA>2!). In property, as with banks, asset backing and financial risk management is everything.

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